Exposure to Real Estate in Bank Portfolios

We implement a three-step procedure to assess the extent of exposure to real estate in commercial banks. First, we investigate the determinants of delinquency on real estate loans. We find the changes in interest rates and income to be the major determinants of aggregate delinquency rate. In the second step, we adopt a stress testing approach to calculate the potential impact on banks’ position of any adverse changes in these determinants. These calculations suggest that a 1.3 percentage point increase in mortgage interest rate leads to a 20% decrease in a typical bank’s distance to default. Finally, we look at the cross-sectional differences to identify the most vulnerable banks. Banks with rapid loan growth along with high cost-income ratio appear to be the most likely to experience a deterioration in their soundness.